Why We Like Banks
Why We Like North American Banks
When you think about a bank in its most basic form, a bank is really a portfolio of loans and other interest-producing assets financed with customer deposits, debt, and shareholder equity. When analyzing a bank as an investment, there are two important aspects worth considering that can dramatically increase the odds of investment success. The first and foremost consideration is asset quality. In banking, your assets help determine your profits; accordingly, if you have an overabundance of non-performing loans, future profitability will be hurt. The second key consideration is a bank’s regulatory capital base. The typical bank has around $1 of equity for each $15 in assets, and so even a 7% decline in asset values would render the bank technically insolvent. This highlights the extensive use of leverage by banks and the fragile nature of the business model. If a bank has a weak capital position, shareholders are exposed to the risk of value deterioration from equity dilution.
If you think back to the 2008/2009 financial crisis, many banks failed because their equity was wiped out, they applied too much leverage, and they held too many toxic assets. Fast forward to today: the US banking system has recapitalized and cleansed itself of toxic assets, and generally, banks have clean balance sheets, low leverage, strong capital, and attractive valuations with price-to-earnings multiples of around 12 times forward profits. When you combine these factors with the current economic climate in the US, which exhibits strengthening employment and reasonable economic growth, the investment case for this sector is further strengthened. We think that an increase in earnings and price-to-earnings multiples are highly likely over the medium term.
Canadian banks exhibit many of the same features as their US counterparts: high asset quality, reasonable leverage, strong capital, and similar price multiples. However, the main differentiator is the economic backdrop. While the US banks appear to have the wind at their backs, the Canadian banks appear to have wind in their faces. The Canadian consumer is highly indebted and reluctant to take on additional debt. In addition, new rules introduced by the Federal Government are designed to limit mortgage growth and put the brakes on a runaway housing market. From our perspective the main issue overhanging the Canadian banks is growth. While interest rates and net interest margins are among all-time lows, aggregate profitability across the sector is at an all-time high. Going forward, if the Canadian banks struggle to grow they will need less capital and will be able to return more capital to shareholders through dividends and share buybacks. With the average dividend yield around 4% and the ability to add 1 to 2% in returns through share buybacks, it is realistic to assume that the industry will be able to generate a reasonable total return for shareholders over the medium term. If you combine the flexibility of this business model with a credible growth platform and the ability to deploy capital towards attractive growth opportunities in international markets, it is not unreasonable to expect a solid total return from a few select Canadian banks despite the challenging economic conditions at home.
European banks require an entirely different discussion. Many of the banks across Europe have yet to take their medicine, as conflicting regional interests and no coordinated intervention mechanism have largely perpetuated the status quo since the financial crisis. Negative interest rates and an abundance of toxic assets have prevented the banks from naturally refreshing their capital bases over time. With low asset quality and weak capital positions, many banks across Europe continue to muddle along and are incapable of adjusting their business to the current economic climate in the region. In addition, many European banks are reliant on the capital markets for funding, and this less deposit-centric business model lends itself to greater instability. Going forward, we’re likely to avoid investing in European banks until the system is rejuvenated and cleansed of non-performing assets.
Our practical approach to risk management focuses on business valuation, balance sheet strength, and risk exposure limits and is designed to ensure that client portfolios have sufficient diversification. While the negative sentiment surrounding banks is unlikely to abate anytime soon, we think it’s important for investors to focus on the fundamentals of the business and to invest for the long term.